Life Insurance and Taxes: What to Know
Payouts to beneficiaries aren't usually considered taxable income. However, those with a cash value policy may have further tax obligations.
Are life insurance proceeds taxable?
In general, death benefits paid out to beneficiaries aren’t taxable, but there are some cases in which life insurance proceeds can be taxed. This comes down to the type of policy you have and the type of payout you receive. Some life insurance policy types have a savings component, while others can be viewed as investment vehicles by the IRS. Many of these policies allow access to life insurance proceeds before the death of the insured, increasing the likelihood of them being considered taxable income.
We’ll discuss the types of life insurance payouts and their tax consequences in greater detail below.
Is life insurance taxable?
Life insurance can have certain tax implications depending on the specifics of the policy and circumstances. While life insurance death benefits are generally not considered taxable income for the beneficiaries, there are exceptions. Situations such as selling a life insurance policy, taking cash withdrawals from the policy, or earning interest on the policy can create taxable events.
|Life Insurance Component||Taxable?|
|Death Benefit Payouts||Generally no|
|Surrendering the Policy||Yes|
|Cash Value Withdrawals||Yes, for the amount above the premiums paid|
|Policy Loans||Yes, under specific circumstances|
|Selling the Life Insurance Policy||Yes|
Here are a few key aspects:
Death Benefit Payouts: Generally, the lump sum paid to beneficiaries upon the death of the insured is not considered taxable income. However, any interest that accumulates on the death benefit, if not immediately disbursed, can be subject to tax.
Surrendering the Policy: If you surrender your life insurance policy for cash, any gains above the amount of premiums paid are taxable.
Cash Value Withdrawals: If you have a cash-value life insurance policy and you withdraw more than the amount you've paid in premiums, the excess amount is considered taxable income.
Policy Loans: If your policy is surrendered or lapsed with a loan outstanding, the loan amount could be considered taxable income, up to the amount of gains in the policy.
Selling Your Life Insurance Policy: If you sell your life insurance policy, the amount you receive that exceeds the cost basis (usually the total premiums paid) is taxable.
Are life insurance premiums taxable?
Generally, the amount that is equal to the premiums that you’ve paid is considered tax-free. This is known as the policy basis. Any accrued interest beyond the basis amount is considered taxable income. Payments made toward a life insurance policy are not tax-deductible (except for business owners paying into employee life insurance plans).
Special cases where premiums payments could be deductible might include life insurance used as a charitable gift or for business purposes, where the business is the beneficiary. For the purpose of income tax, life insurance premiums paid by individuals are considered personal expenses and are not deductible.
How life insurance payouts work
You’ve taken out a life insurance policy to provide a sense of security to your loved ones. The core function of a life insurance policy is to provide a financial payout in the event of the insured's death. This is called the death benefit and is paid out to the beneficiary designated on your policy. It is generally not considered taxable. All life insurance policies include the death benefit, which can be paid out in a lump sum or in annual payments.
However, there are other types of policies that go beyond the death benefit. This includes cash value policies (life insurance plans with a savings component) and annuities (less of an insurance policy and more of an investment vehicle). These policy types allow access to money before the death of the insured through a savings or investment component. Depending on how and when the money is accessed, this can have further tax implications.
When life insurance proceeds are not taxable
These are the situations in which proceeds received from a life insurance policy are not considered taxable income.
Standard death benefit
In most cases, a death benefit payout is not considered gross income by the IRS and therefore does not have to be reported as such. In a standard life insurance policy, a beneficiary is selected to receive a payout after the insured person passes away. If the beneficiary only receives the death benefit in a lump sum it is not subject to taxes. However, benefits paid out in installments could accrue interest which could be considered taxable.
Accelerated death benefits
Death benefits accessed before the insured's passing are not typically taxed. These benefits are typically accessed by terminally ill patients who require the money to pay for expensive medical care. While not taxed in the event of a lump sum payout, you could face a tax bill if you are paid out in increments, as these could accrue interest.
Also important to note is that this "living benefit" requires that you continue to pay your premiums for the duration of your policy.
Similar to accelerated death benefits, viatical settlements are another option available to terminally ill policyholders. This option involves selling a portion of the policy to a third party or entity, typically a company that specializes in such transactions. You'll receive the money for the policy to take care of medical and living expenses, but the benefits will be paid out to the new owner upon the insured's passing.
Unlike accelerated death benefits, viatical settlements don't require that the insured continue to make premium payments, as these are likely to be covered by the purchaser.
When tax proceeds are taxable
While death benefits typically aren’t considered taxable, there are situations in which proceeds from your life insurance policy can be taxed. Holders of a cash value life insurance policy are especially likely to see tax implications arise from their policies.
Certain types of life insurance policies accrue interest over time. This interest is considered tax-deferred until it is accessed by the policy owner. The amount that is considered taxable is anything over the amount that you paid through premiums.
For instance, if you have paid $15,000 of premiums, but your policy's current cash value is $17,500, only the amount above $15,000 ($2,500) is considered taxable, as it represents investment gains.
Surrendering your policy for its cash value is likely to result in a tax bill. Any amount received over the policy’s cost basis — the amount you paid in premiums — is subject to tax. Cashing out the policy early means that death benefits will not be paid out.
While this may not be an option for everyone, it is often available to those 65 and up or who meet certain medical requirements. Life settlements, as they are often called, involve a broker who handles such transactions on your behalf. The proceeds from the sale of your policy are often subject to tax.
The new owner of your policy will take over premium payments and will receive the benefits upon your passing.
Loans taken out while the policy is in force are not considered taxable but could be taxed if the policy lapses before the loans are paid back. If you withdraw less than the amount in premiums that you have paid, the money will not be subject to taxes.
If the proceeds are paid out to an estate instead of an individual, those inheriting the estate may have to pay estate taxes. Furthermore, if proceeds exceed the maximum threshold that your state allows, they could be subject to tax. Note: this currently only applies to estates worth over $12.92 million (as of 2023).
In general, it's always a good rule of thumb to name a beneficiary on your policy. This can help you avoid the higher inheritance taxes involved with insurance proceeds going to your estate instead of an individual.
In most cases, death benefits are not taxed. However, beneficiaries who choose to delay the benefit or take it in installments run the risk of incurring a tax bill. This is because the benefit continues to accrue interest from the insurer.
Taxes by life insurance type
Your tax situation can vary depending on the type of life insurance policy that you have. Below, we’ll break down the different types of life insurance products and highlight their tax implications.
|Life Insurance Type||Tax Implications||Additional Details|
|Term Life Insurance||Unlikely to incur a tax bill||Term life insurance only offers a death benefit and has no savings component, which means there are usually no taxable events.|
|Cash Value Policies (Whole, Universal, and Variable Life Insurance Policies)||Taxable interest can accrue||The savings or investment components in these policies can result in accrued interest beyond the value of the death benefit. This accrued interest will be taxed.|
|Modified Endowment Contracts (MECs)||Early withdrawal penalties apply||Withdrawing from your policy before the age of 59.5 can result in a 10% tax penalty. In addition, policy loans, surrenders, and dividends are treated as income and are taxable.|
|Employer-paid Life Insurance Premiums||Potentially taxable||If an employer pays life insurance premiums, it could be included in the employee's taxable income as a fringe benefit.|
|Surrendered, Sold, or Lapsed Policies||Potentially taxable||If a policy is surrendered, sold, or lapses with an outstanding loan, it may result in taxable income.|
Term life insurance
Term life is a form of life insurance coverage that is active for a set amount of time. Terms can range in length from five to 30 years. Rates can increase at the onset of a new policy term, though this policy type often remains cheaper overall than whole life or other cash value policies.
As this coverage type offers only a death benefit — with no saving component — it is not likely to incur a tax bill.
Cash value policies
The following policy types all include a savings or investment component that can result in value beyond the death benefit. These types of policies often have further tax considerations, especially if the policy is surrendered or sold.
Whole life insurance is a permanent form of life insurance coverage that offers death benefits and a cash-value component. This means that the premiums you pay build equity that can pay out in advance of the insured’s death. Premiums do not rise as they do with term policies, though the prices for a whole life policy are higher in general. Interest accrued is subject to tax.
Universal life insurance is another form of permanent life insurance coverage that accumulates value over time. In addition to the death benefits, universal life policies accrue interest related to a specific stock index.
Variable life insurance policies are similar to universal life plans in that they accrue interest through returns through a number of financial instruments, namely stocks, bonds and equity funds. Like other cash-value policies, accrued interest is considered taxable income.
Variable universal life insurance allows the policyholder to exercise greater investment control, possibly yielding greater results. This also poses more risk, however, as returns on such investments are not guaranteed. Accrued interest is considered taxable income.
Term life insurance vs. cash value
- Only pay out death benefits
- Are in place for a set period of time
- Are cheaper in general
Cash value policies:
- Pay out death benefits
- Have a savings or investment component
- Are considered "permanent" policies
- Are likely to incur tax bills
Modified endowment contract
Some policies are categorized as modified endowment contracts (MECs), meaning that the IRS no longer considers them to be life insurance policies in the typical sense. This designation was put into place to help cut down on tax avoidance. Essentially, it helps to prevent policy owners from paying too much into their tax-deferred life insurance policy. The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 7-pay test.
If your policy is considered a modified endowment contract, withdrawing from your policy before the age of 591/2 could actually bring about a tax penalty of 10%. Those with a MEC should consult a tax professional to find out more about tax guidelines.
The IRS definition of a modified endowment contract
- Was in force on or after June 21, 1988
- Fails to meet the 7-pay test*
- Meets the definition of a “life insurance contract” as outlined in the Internal Revenue Code (Section 7702)
*According to the IRS, "A contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first 7 contract years exceeds the sum of the net level premiums which would have to be paid on or before such time if the contract were to provide for paid-up 'future benefits.'"
How to avoid tax liability on life insurance
Life insurance provides financial security for your loved ones after your death. However, certain aspects of life insurance may be subject to tax. Luckily, there are strategies you can use to minimize or avoid these taxes:
1. Choose Lump Sum Over Installments: When it comes to death benefit payouts, beneficiaries can typically receive the money tax-free. However, if the death benefit is paid out as installments instead of a lump sum, the interest portion of the payments could be subject to income tax. To avoid this, beneficiaries may choose to receive the death benefit as a lump sum.
2. Utilize Estate Planning Tools: If the life insurance payout significantly increases the value of your estate, it could be subject to estate taxes. To avoid or minimize this, consider using estate planning tools such as wills or trusts. For instance, an irrevocable life insurance trust (ILIT) can remove the death benefit from your taxable estate, preventing it from increasing the estate's value and potentially incurring higher estate taxes.
3. Be Aware of Modified Endowment Contracts (MECs): If your policy is classified as a MEC, withdrawals, loans, or dividends may be taxed. If you want to avoid these taxes, ensure your policy does not become a MEC by not overfunding it.
4. Avoid Surrendering or Selling the Policy: Surrendering a life insurance policy for cash or selling the policy can result in taxable income. To avoid these taxes, consider other options such as borrowing against the policy instead of cashing it out.
Remember, everyone's tax situation is different, and these strategies may not work for everyone. It's always a good idea to consult with a tax professional or financial advisor to understand your specific circumstances and potential tax obligations.
Life insurance and taxes: considerations
Life insurance is a great way to safeguard against unforeseen circumstances and to keep your family protected. Knowing how such a policy works and the possible tax implications it carries is an important part of your estate planning that can have financial consequences on your loved ones. If you are uncertain about what the tax consequences of your life insurance are, you can always consult a tax professional, financial advisor or life insurance agent to find out more.
Life insurance and taxes: FAQs
Below you'll find quick answers to tax-related questions about life insurance.
Are life insurance payouts taxable?
The beneficiary of a life insurance payout does not have to pay taxes on a death benefit received from a life insurance policy in most cases. Deferring the payout or taking it in installments could result in the accrual of interest that could be considered taxable.
Can I claim insurance premium payments as a tax deduction?
Unless you are making such premium payments on behalf of employees of your business, the IRS does not allow you to claim life insurance premium payments as deductions.
Are life insurance dividends taxable?
Generally, no, as the IRS sees these a rebates for premiums paid. However, if those dividends accrue interest you can expect that to be taxed.
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